Taxing times: rental property foreclosures and short sales.

• Author: Fogel, David M.
• Position: Taxguidance

i recently reviewed the tax consequences of foreclosures and short sales involving a taxpayer's principal residence (January/February California CPA, Page 11), but what happens if the property involved is a rental? Is there a similar exclusion of cancellation-of-debt income (CODI) under Internal Revenue Code See. 108 for rental properties?

Recourse or Nonrecourse Debt?

Nonrecourse debt: lender cannot hold the borrower personally liable for it and may go only against the value of the property that is securing the debt to collect.

Recourse debt: lender can hold the borrower personally liable for it beyond the value of the property that is securing the debt.

If there is any doubt about whether the debt is nonrecourse or recourse, a real estate attorney should be hired to review the loan documents and make the determination.

For purposes of this article, assume the rental property debt is recourse debt.

Tax Consequences

If a lender discharges any part of a debt, then the taxpayer must recognize the amount discharged as ordinary income [IRC Sec. 61(a)(12)]. Where the unpaid indebtedness is recourse, the foreclosure, or short sale, transaction is split into two parts: CODI equal to the outstanding principal amount of debt owed minus the fair market value of the property; and gain or loss equal to the fair market value of the property, minus its adjusted basis [Treas. Reg. Sec. 1.1001-2(a)(2)].

If the borrower qualifies, one or more of the relief provisions available under Sec. 108 may be used to exclude the CODI. One such provision is the Qualified Real Property Business Indebtedness (QRPBI) exclusion [Sec. 108(a)(1)(D)], to which California conforms.

To qualify for this exclusion, the debt must be incurred or assumed by the taxpayer before Jan. 1, 1993, in connection with real property used in a trade or business (or if incurred or assumed after that date, is "qualified acquisition indebtedness") and is secured by the real property [Sec. 108(c)(3)(A) and (B)]. The taxpayer must make an election to exclude the CODI [Sec. 108(c)(3)(C)].

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If the taxpayer qualifies for this exclusion, then the CODI is excluded from gross income and applied instead to reduce the taxpayer's adjusted basis of the property [Sec. 108(c)(1)]. The exclusion is limited to the excess of the principal amount of the qualified debt over the fair market value of the property [Sec. 108(c)(2)(A)], and also limited to the taxpayer's basis in the property [Sec...